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This paper was written as a briefing for the Multi-stakeholder Consultations on ‘Sovereign debt for sustained development: Issues for countries that access financial markets’ held at the United Nations in New York on 7^th and 8^th March 2005

Debtor-creditor relations in good times and bad

By Susanna Mitchell Jubilee Research @ nef

The issues paper prepared by Financing for Development Office at the United Nations in preparation for the multi-stakeholder consultations on sovereign debt for sustained development states that ‘The expectation is that stake holders will want to focus their discussions on practical and realizable policies and processes for managing external sovereign debt.’  If these discussions are to have any lasting value, however, they require a dual focus. Creditor-debtor relations do not exist in a vacuum, but are a feature of a world economy that has facilitated and frequently encouraged excessive accumulation of liabilities by middle income countries, and this situation cannot remedied simply by examining measures for resolving or averting recurrent debt crises within the present economic framework. Therefore, while attention must be directed towards finding a short-term solution to the immediate problems of severely debt-distressed economies, through such means as the independent arbitration process described below, it is also critical that consideration be given to broader long-term proposals for a more fundamental reform of the current financial system, in order that the requirement for developing country borrowing (and especially the need to contract unproductive defensive loans) may be reduced in the future without compromising human development.

A brief outline of both the short-term and the long-term objectives is given below.

Since the 1970s the external debt of middle income countries has risen inexorably, and has reached unprecedented levels. An illustrative sample of six highly indebted MICs, Ecuador, Peru, the Phillipines, Turkey, Indonesia and Brazil is given in Chart 1 below.

According to the World Bank, the ratios of external debt to GNI for all these countries were in excess of 50% in 2002, and apart from the Philippines they all have debt to export ratios that fall below the sustainability threshold even of World Bank HIPC sustainability criteria   (See Table 1 below).

There have been a number of middle income country defaults since the early 1980s (the most recent being Ecuador in 2000 and Argentina in 2001) and the greater use of market borrowing by such economies, coupled with the increasing volatility of global capital flows, has greatly increased their vulnerability. As a result, the likelihood of further defaults is high, and this risk is exacerbated by the tendency of private lenders to rush to reduce their exposure as soon as an economy is perceived to be under stress  – thus creating a self-fulfilling prophesy of economic collapse.

Even when outright default is avoided, such a situation does not serve to further the progress of developing countries. To the contrary, the deflationary policies adopted by debt-distressed emerging economies in order to placate their creditors have typically resulted in depressed growth; and where IMF bailouts have been involved, dictates demanding the maintenance of high primary fiscal surpluses for the payment of debt servicing have cut public spending and impacted severely on the poor. This causes great hardship among large sections of the population, and reduces the domestic demand upon which the long-term sustainability of an economy must rest.

It should be noted that the desperate levels of poverty within many heavily indebted LICs has tended to overshadow the very real problems experienced in many MICs. In fact, nearly a third of those living on under $1 a day live in MICs and not all MICs are on target to meet their MDGs.[2] In many countries, figures for per capita GNI mask huge regional and cultural differentials of income. In Peru, for example, per capita GNI is given as $2,020 (using the Atlas method) but over 18% of the population live below $1 a day, and 37.7% below $2 a day. In Brazil, one of the richest of the developing countries, where GNI per capita is given as $2,830, 8.2% of people live on under $1 and 22.4% under $2 per day; this represents over 53 million people living in poverty.[3]

Despite recurrent crises, however, the framework for restructuring debt obligations remains inadequate. As things stand, there is an understanding that multilateral creditors such as the World Bank and the IMF hold preferred creditor status, but there are no agreed restructuring procedures among private creditors, who perceive themselves at a disadvantage in such arrangements. In certain cases this can indeed be so, as is clear from the ongoing debt negotiations between Argentina and its creditors, where a large proportion of government bonds held at the time of default appear to have changed hands as the result of a dubious debt swap in the run-up to economic meltdown, and where the banks, institutions and individuals who mastermind the deal cannot be held accountable for their actions.

Most critically, the present creditor-led system makes it impossible for sovereign debtors to escape from debt burdens that are often caused as much by reckless lending as by unwise borrowing, and that frequently include a large proportion of ‘odious’ or illegitimate debt knowingly extended to undemocratic or corrupt governments in the past. The many loans that have been made for irresponsible purposes, such as inadequately researched infrastructure projects or unproductive military expenditure, are also overlooked, while the fact that the principle of much debt has been paid many times over due to rescheduling and rising interest rates is similarly ignored.

An outcome that enables debt-distressed MICs to ensure the basic social and economic rights of their peoples clearly cannot be achieved within such a framework, in which the plaintiff is both judge and jury in the decision process. Nor can fruitful creditor-debtor relations be maintained unless a legitimate, transparent and accountable judicial system is in operation to ensure that dubious practices, such as the Argentine Mega-swap, are declared illegal. Moreover, although it is clearly necessary for a lender of last resort to have some degree of exceptional protection, bad advice on the part of international financial institutions should be penalised, and defensive lending discouraged. Creditor controlled proposals such the Sovereign Debt Restructuring Mechanism (SDRM) and the emergence of collective clauses for creditors (CACs) do not even begin to solve these problems.  

We therefore consider that a human development approach to the problem is essential, and recommend that an independent arbitration process be established without delay to adjudicate cases of sovereign debt distress. Several detailed proposals for such a process are already on the table, including the Jubilee Framework.[4] A brief outline of the Fair and Transparent Arbitration Process (FTAP) is given in Annex 1 below. 

Were such a process to be adopted, it would serve as a guarantee of fair dealing to creditors and sovereign debtors alike. In ‘good times’ its existence would discourage both rash lending and unwise borrowing, and in times of distress it would provide a forum where a just and humane resolution to actual or incipient sovereign insolvency crises could be decided by a neutral and independent adjudicator. The temporary capital controls imposed during the judicial process would ensure that the balance of payments problems associated with a ‘rush to the exit’ by investors and lenders were circumvented.

2. The long-term objective: a new global financial architecture

The underlying structural problems that have resulted in MIC economic crises are global in nature and remain unresolved. If creditor-debtor relations are to be stabilised in the long-term in such a way as to maximise poverty reduction and human development, inherent flaws in the international financial system will need to be remedied.

In order to fulfil this objective, the international system must be based on three fundamental principles:

• Finance should serve human development, rather than development and national economies serving finance

• External debt problems cannot be examined in isolation from other liabilities, including foreign equity investment, FDI and domestic debt

• Economic crisis must be recognised as a systemic problem that cannot be resolved through an incremental or county-by-country approach

Over the last two decades, it has become increasingly clear that the present financial architecture, far from preventing the boom-bust cycles that wreak so much havoc in the developing world, actually creates them. Following the debt crises of the 1980s, the global economy has continued to be subject to severe shocks, of which the Mexican, Asian, Russian, Brazilian and Argentine crises are amongst the most notorious examples. As a result, and despite overall progress as a group, the development of middle income countries over the last two decades has been fragile and uneven. Over the last 20 years, 38 countries have fallen back from MIC to LIC status, with only 10 managing to return to MIC status in subsequent years,[5] while millions more have become impoverished within the MICs themselves. Following the Asian crisis in 1997, over 100 million were reduced to poverty in Indonesia alone, and afflicted economies in all continents continue to struggle with unsustainable burdens of external and domestic debt.

Many factors can precipitate crises; a severe fall in commodity prices, a rise in global interest rates, an overvaluation of the currency due to excessive inward flows leading to unsustainable trade and current account deficits, and the herding behaviour of investors which creates, and then bursts, speculative bubbles in asset markets. It is therefore vital to bear in mind that the circumstances that generate unsustainable debt burdens, and the balance of payments problems that precipitate eventual meltdown, cannot be looked at in isolation, but are the result of much wider failures within the global economic system as a whole.

These failures are distinct, but inter-related. Premature financial liberalisation has dangerously increased currency volatility, while the absence of appropriate regulation of speculative investment and the failure to control tax avoidance have exacerbated the problem. Excessive pressure on developing countries to increase commodity exports, compounded by IMF and World Bank conditionality, has resulted in the collapse of global commodity prices, while rich country subsidies have made a nonsense of the trade liberalisation policies forced on developing economies. In addition, the absence of redistributive measures such as land reform and progressive taxation systems, coupled with grossly inadequate development aid (still less than one third of the 0.7% of GNI committed by developed country governments in 1970), have further increased inequality both within and between countries. In turn, this has depressed the domestic demand that is essential for stable economic prosperity and poverty reduction. Any attempt to solve the problem of sovereign debt without also addressing these interlinked factors can only be regarded as a temporary palliative.

More narrowly, since external sovereign borrowing is only one of several ways in which most MICs can acquire capital, it is even more unrealistic to discuss this particular form of funding in isolation from other sources, in particular equity and foreign direct investment, and domestic debt. As far as the former goes, it should never be forgotten that all external financing, whether in the form of loans, portfolio investments or FDI, gives rise to external liabilities, and that FDI can run dry, and equity investments can be – and are – abruptly withdrawn from developing countries as soon as investor confidence wavers. As noted above, this retreat creates a self-fulfilling prophecy of economic disaster, compelling stricken governments to incur more debt obligations, typically in the form of bailouts from the IMF and other official creditors, in order to salvage the balance of payments situation.

Disproportionate emphasis has been placed on the importance of external financing in recent years, and this has led to an implicit assumption thatthe foreign exchange effects of direct and equity investment in developing countries are inherently positive. This perception, however, should be questioned; in fact, although data on direct and equity flows, profits and FDI-related trade are extremely problematic and incomplete, it would appear that the long-term effects of foreign ownership will typically be negative, except where completely new productive capacity is created in a strongly import-substituting sector of the economy or in export sectors where increased production will not substantially reduce world prices.[6] It cannot be over emphasised that foreign capital in any form is beneficial to the host country only to the extent that the resources it generates remain within the host economy, and that the profits and capital gains reaped by foreign investors represent a foreign exchange cost. Policies that mobilise domestic resources and increase domestic demand are likely to be much more effective in promoting sustainable growth than a resort to external financing, and although some low income countries may suffer from an acute shortage of such domestic resources, middle income countries are typically in a position to be much more self-reliant than at present.

Such self-reliance helps to protect the autonomy of developing country governments – a freedom that can be progressively lost in an economy heavily dependent on foreign investment. In such an economy, the outward flow of profits will rapidly escalate, and in order to balance this and maintain an inward net resource transfer, it will become vital to attract a similarly increasing volume of new inward investment. This need places a great constraint on social, environmental, and fiscal policies, which become skewed towards the priorities of actual and prospective foreign investors and transnational companies, rather than the needs of the host country’s population. At the same time, it progressively transfers ownership of productive capacity from local people and companies to TNCs. Where this situation is combined with an escalating debt burden, requiring the maintenance of a high fiscal surplus for the servicing of public debt, social spending is inevitably further curtailed in order that creditor demands may be met, while in the aftermath of acute crisis, where restructuring agreements have been sought from the Paris Club or bailouts have been accorded by the multilateral institutions, the conditionalities imposed on the loans not only remove the opportunity for national governments to determine their own economic policies in the short term, but progressively erode their capacity to do so in the long term. Not infrequently, this loss of autonomy also subjects an indebted nation to extreme pressure to conform to the political agendas of its creditors.

A country’s domestic debt burden is another critical factor in the overall equation. While foreign debt cannot be considered in isolation from other external liabilities such as FDI and inward equity investment from a balance of payments perspective, it must also be considered in combination with domestic government debt from a fiscal perspective.

In many middle-income countries, domestic government debt represents a major additional burden on the public finances. In Brazil, for example, the public sector’s domestic debt is nearly three times the size of its foreign debt[7]. In many cases, including Brazil, this is in large measure a result of the failure of the debt strategy to resolve the fiscal dimension of MICs’ external debt problems. While the psychological effect of the Brady Initiative was sufficient to attract in new capital flows, easing the balance of payments effects of foreign debt, the actual reduction in debt-service payments was generally limited or zero (and may in some cases have been negative)[8]. Since the new capital inflows went to the private rather than the public sector, governments were left to borrow domestically, in effect refinancing foreign debts with domestic.

However, domestic interest rates in MICs have generally been much higher than international rates over the last fifteen years, both nominally and in real terms – reflecting the need to attract foreign commercial capital in a context of poor economic performance and high instability, coupled with IMF conditionality.  The result has been a massive increase, not only in MICs’ domestic debts, but also in their overall indebtedness; and an ever-tightening constraint on their non-interest spending as interest payments have risen. Thus Brazil’s total public sector debt increased from 30% of GDP in 1994 to 52.6% in 2001, domestic debt accounting for more than 90% of the increase[9]. (See Chart 2 below)

Preventing future debt crises – the need for systemic change

A failure to consider the inherently inter-related nature of the various factors outlined above can only result in a perpetuation of the boom-bust economic cycles that have plagued developing country economies since the early eighties. In a volatile financial environment, predicated on servicing the needs of international capital and protecting creditor assets, the measures available to developing countries to ensure their ability to service their external debt obligations are self-evidently ineffective. Indeed such policies are frequently damaging in themselves: the maintenance of high levels of foreign reserves locks up scarce resources in an unproductive fashion; undue emphasis on the export sector frequently results in production that undermines domestic food security, and to overproduction that impacts adversely on global commodity prices; over reliance on volatile foreign capital flows lays economies open to severe shock when funds dry up, or are withdrawn; and the need to attract ever-growing inflows creates rapidly escalating liabilities and financial risks, destroys debtor-government policy ‘ownership’, and pushes up domestic interest rates adding to fiscal strain.

Unless this unhealthy and exploitative paradigm is replaced by a global economic system that prioritises human development not simply over creditors’ property rights, but over the unaccountable demands of the international financial capital markets, there can be no hope of a long-term solution to the problem of sovereign debt crises. A fairer arbitration and restructuring process may bring temporary relief to economies in acute distress, but such a country-by-country approach cannot cure the underlying problem. Nor, as the aftermath of recent crises has shown us, can the present system offer an appropriate policy response in cases of widespread economic collapse such as the Asian or Russian meltdown.

Fortunately, the momentum of financial capital is not generated by an elemental force, but by human beings and the technology they deliberately choose to operate, motivated by the incentives created by national policies and the international financial system. It is therefore perfectly possible for national governments and citizens, working together through representative bodies, to devise a new financial architecture that is based on a human development approach – one that incorporates international coordination mechanisms and regulations to tame and control a global money market that is currently failing to function for the benefit of human wellbeing.

Such a system would aim to reverse the present flow of global wealth from South to North, and prevent the gross misallocation of resources that is currently hindering poverty reduction, increasing inequality and threatening world peace. Many of the components of this new architecture have already been proposed and developed. Among them are: 

• The replacement of the Bretton Woods Institutions (BWIs) by alternative impartial democratised international organisations[10]

• The establishment of an international currency transaction tax (CTT) to curb speculation on the foreign currency markets and reduce volatility[11]

• The setting up of a global intervention fund to be used in combination with a system of crawling peg exchange rates and intervene automatically in support of currencies under speculative attack, to smooth exchange rate adjustments[12] 

• The appropriate use of national capital controls in order to regulate both inflows (as in Chile in the early 1990s) and/or outflows (as inMalaysia in 1998) [13]

• Mechanisms for the international coordination of national taxes to limit tax competition, and the imposition of strict regulation and supervision of Off Shore Financial Centres (OFCs) in order to control tax avoidance[14]

• Adequate measures to limit the accumulation of liabilities and discourage speculative bubbles in asset markets, including the collection of reliable data on the net resource flows arising from equity investments and FDI.

• Policies to expand and promote domestic and local resources, including the redistribution of land where appropriate

• Measures to promote developing countries’ access to appropriate forms of external finance on favourable terms for priority uses.

• International regulations to prevent loans, guarantees and insurance by national export credit agencies (ECAs) for projects that detract from sustainable development

• The replacement of the present global payments system by a new institution such as an International Clearing Agency and/or measures to institute a new global currency for international transactions.

• The introduction of a fair international trading system that recognises the need of developing countries to protect their economies, and does not discourage the expansion of their internal domestic markets or promote unsuitable export production.

A global economic system that incorporates the above principles would allow national governments to control their policy decisions according to their development needs, in particular allowing them to safeguard their currencies by resisting inappropriate liberalisation policies, especially capital account liberalisation. By calming currency volatility, the new institutions would function automatically to reduce the likelihood of balance of payments crises, strengthen public sector finances and limit cases of sovereign debt distress. During the transition period, an arbitration process such as FTAP could be used to restore economies with existing unsustainable debt overhangs to economic viability.

There is, of course, no guarantee that all developing countries would use their enhanced policy autonomy to pursue prudent macroeconomic policies; nonetheless it is clear that under present conditions they literally cannot do so, since they are effectively disempowered by an economic system that is inherently exploitative, and by financial markets against which they have no protection.

If we wish to promote human development, avert economic crises, stabilise economic cycles and promote good creditor-debtor relations, bold steps must be taken to reconfigure our financial architecture. If we shy away from this challenge, our efforts to solve sovereign debt crises will be short-term palliatives only, for we will simply be treating the symptom and ignoring the disease.

ANNEX 1
Independent Arbitration
FTAP  - A fair and transparent arbitration process

The FTAP/Chapter 9 Framework[15] applies the principles of domestic bankruptcy law enshrined in Chapter 9 of the US Legal Code to cases of unsustainable sovereign debt, and provides for an independent third party to make judgements on the claims of the creditors.

The role of ensuring the neutrality of the panel is assigned to the Secretary General of the UN.

An automatic stay of debt payments to all creditors is imposed for the duration of the judicial process, in order to prevent asset grabbing

1. Rapidly to return debt distressed economies to sustainability
2. To maintain that sustainability into the future

• Impartiality of decision making.  Unlike the present system where the creditor plays the role of plaintiff judge and jury, FTAP will enshrine the proper independence of the insolvency court.

• Neutrality of Assessment. Assessment of the debtor’s economic situation will be made by a neutral body which does not represent the interests of either debtor or creditors.

• Transparency.  Negotiations are open to public scrutiny and recorded.

• Participation.  Civil society holds the right to access information, and to be heard during negotiations

• Monitoring. Civil society will critically review the implementation of the FTAP outcome

• Debtor’s unconditional right to petition. Sovereign debtors hold unconditional right to petition to enter the insolvency procedure

• Protection. Both the sovereignty of the debtor country and the human, social and economic rights of its citizens will be protected, including the country’s ability to achieve its MDGs.

• Conditionalities established by debtor country. Economic and political measures upon which debt relief under a FTAP is conditional must serve the poor sectors of the debtor society. These will be proposed to the panel by the debtor government, and subsequently monitored by all stakeholders.

Benefits of FTAP

• Restoration of debtor country viability. FTAP would be modelled on Chapter 9 of the US Legal Code, which stipulates that the debtor must emerge from insolvency proceedings with adequate prospects of financial and economic stability, including a sufficiency of capital

• Fairness of outcome.  Because FTAP is impartial, it will be fair to both debtor and creditors. The process will discourage both reckless lending and unwise borrowing in the future.

• Burden sharing among creditors.  BWIs should shoulder their fair share of debt cancellation as adjudicated under FTAP

• Debtor country autonomy protected.  Debtor country governments will be able to devise and implement their own poverty reduction and development policies free from external coercion.

• Odious debt.  Illegitimate or odious debt will be objectively determined. (Outside such an impartial process, the definition of what is ‘odious’ is always a subjective decision by one or other party in the dispute.)

• Domestic debt.    Many developing countries have very high domestic debt burdens, arising both from the need to service external debt and from the effect of creditor-imposed conditionalities, and it is impossible to estimate indebtedness (or ensure adequate resources for the MDGs) unless these are taken into consideration. FTAP will enable a holistic assessment of debt sustainability.

• Low cost of procedure. FTAP will not require a standing court, but can be convened where necessary, modelled on the many existing examples of independent arbitration procedures for debtors and creditors.

[1] Statistics from the World Bank Global Development Finance, 2004

[2] UK Department for International Development, Achieving the Millennium Development Goals:the Middle-Income Countries.  A strategy for DFID:2005-2008

[3] World Bank Human Development Indicators 2004

[4] See Chapter 9/11? – Resolving international debt crises – the Jubilee Framework for international insolvency at http://www.jubileeresearch.org/analysis/reports/jubilee_framework.pdf

[5] UK Department for International Development, Achieving the Millennium Development Goals:the Middle-Income Countries.  A strategy for DFID:2005-2008

[6] See David Woodward, The Next Crisis? Direct and Equity Investment in Developing Countries, Zed Books 2001

[7] Fabio Giambiagi and MarcioRonci (2004), “Fiscal Policy and Debt Sustainability: Cardoso’s Brazil, 1995-2002” – Table 14. IMF Working Paper WP/04/156.

[8] EURODAD (1996), World Credit Tables, 1996 – chapter on Commercial Debt. European Network on Debt and Development, Brussels.

[9] Giambiagi and Ronci (ibid.).

[10] David Woodward, New Economics Foundation, London. Alternative Structures to the IMF and World Bank, December 2004

[11] Advanced plans for a 2-tier version of the Tobin Tax is already on the table

[12] David Woodward, Time to Change the Prescription: a Policy Response to the Asian Financial Crisis, Special Briefing paper, Catholic Institute for International Relations, London, 1999.

[13] The necessity for capital controls is well documented.  For instance UNCTAD's Trade and Development Report 1998 makes a central point that to protect themselves against international financial instability, developing countries need to have capital controls, since these constitute a proven technique for dealing with volatile capital flows.

[14] The recent work of the Tax  Justice Network is at the forefront of this reform. See John Christensen and Richard Murphy, the Social Irresponsibility of Corporate Tax Avoidance: Taking CSR to the bottom line Development (2004) 47(3) 37-44. doi:1010.1057/palgrave.development.1100066

[15]See Chapter 9/11? – Resolving international debt crises – the Jubilee Framework for international insolvency at http://www.jubileeresearch.org/analysis/reports/jubilee_framework.pdf